Summary
- We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks.
- In this post we provide a simulation-based (sim-based) assessment () of this assumption.
- Our results suggest that growth stocks may do better under relatively high inflation than value stocks.
The nonlinear relationship between the PE ratio and earnings growth
In a previous post () we have shown that there is a nonlinear relationship between the price/earnings (PE) and the price/earnings to growth (PEG) ratios, which are widely used measures of company valuation. The PE divided by the PEG yields the expected growth in earnings, usually for the following 5 years.
Value stock
For the purposes of our discussion, we will consider a fictitious “value” company with a stock price of $100 and expected earnings growth of 10% (real growth of 5%). The PE ratio is 11.89 (see: ), which is considered fair assuming that there is no inflation. (An equivalent assumption, with slightly different simulation parameters, would be that the rate of inflation is covered by the company’s dividend.)
The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $77.76. The reduction (from $100) accounts for the yearly loss of 5% in real terms.
Growth stock
We will also consider a fictitious “growth” company with a stock price of also $100 and expected earnings growth of 75% (real growth of 70%). The PE ratio is 260.47, which is considered fair, again, assuming that there is no inflation (see: ).
The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $80.58. Analogously to what happened with the value company, here the reduction (from $100) accounts for the yearly loss of 5% in real terms.
Comparative performance
The table below summarizes a comparison of the two sim-based estimations for the value and growth stocks. Note that in neither case we assume that the company can pass on the inflation to its customers. As you can see, the growth stock does better under relatively high inflation than the value stock.
What we often hear from experts on business media outlets is that inflation has a much more dramatic negative effect on growth stocks than value stocks. That is not what our simulation suggests.
Final thoughts
Both value and growth stocks should be affected by the expectation of future inflation. If that expectation proves to be incorrect, then an upward adjustment should ensue.
Generally speaking, inflation should be particularly problematic for companies that sell tangible items via influential retailers, because usually the companies have to wait for the items to be sold to get paid.
The above scenario is normally seen in the manufacturing sector, which is usually where value companies are.
If you go back to the sim-based results on the two similar tables, you will notice that at year 10 both value and growth stocks approximately triple in nominal terms – this is what we assume in our algorithms to set our fair values; going “backwards”, so to speak.
But if you look at years 11 and 12, growth significantly outperforms value.
